(1) Technical Field
The present invention relates to risk management. More specifically, the present invention relates to a method, computer program product, and system for estimating an expected annualized loss for use in risk management, such as in seismic risk management.
(2) Description of Related Art
The field of seismic risk management has been gradually developing over the past few decades, increasingly enabled by technological advances in software and driven by a need for more informed property ownership decisions.
Seismic risk enters into several important real estate decision-making processes, such as the purchase of investment property, performance-based design of new structures, seismic rehabilitation of existing buildings, and decisions regarding the purchase of earthquake insurance. In such situations, important factors include, for example, who the decision-makers are, how they make decisions, what aspects of seismic risk most concern them, and the length of their planning horizon.
Economic seismic risk to large commercial properties with commercial mortgages is assessed every time the property changes hands, typically on the order of every five to ten years. By contrast, a building is designed and built only once. Thus, the most common opportunities for market forces to bring about seismic-risk mitigation for commercial properties are at times of sale. Anecdotal evidence suggests that these are mostly missed opportunities, as risk is typically not mitigated, even in more vulnerable buildings.
This can be partly explained by considering the context in which seismic assessments are performed. During virtually every sale of an existing commercial building, the buyer assesses the building's investment value using a financial analysis that considers revenues and expenses, rent roll, market leasing, physical condition, and other property information. The investor makes his or her bidding decision based on projected income and expenses, using one or more of the economic performance metrics of net present value, net operating income, cash flow, internal rate of return, and capitalization rate.
The input to this financial analysis is typically provided by a real estate broker representing the seller, whose FIG.s the investor checks and modifies during a due-diligence study. Many of the inputs are known values, such as the quantity of leases, duration, and income from current leases. However, many other values are uncertain. Vacancy rates, market rents, and other important parameters fluctuate significantly and unpredictably, leading to substantial uncertainty in the future economic performance of a property. In the face of these uncertainties, the bidder usually estimates investment value using best-estimate inputs and then again with deterministic sensitivity studies to probe conditions that would lead to poor performance (higher future vacancy rates, for example). The future cost to repair earthquake damage is not one of the parameters the bidder uses in the financial analysis. This is important because seismic risk is not a market quantity.
The real estate market is not wholly without forces to influence seismic-risk mitigation. The due-diligence study typically includes an engineering assessment of the condition of the property, which itself typically includes an estimate of the earthquake probable maximum loss (PML). PML is by far the dominant earthquake risk parameter in financial circles.
The earthquake PML has no standard quantitative definition. Most working definitions involve the level of loss associated with a large, rare event. One definition is that PML is the 90th percentile of loss given the occurrence of what building codes until recently called the design basis earthquake (DBE). The DBE is an event producing a shaking intensity with 10% exceedance probability in 50 years. Colloquially (and inexactly), this is an upper-bound loss given the 500-year earthquake. More accurately, assuming Poisson arrivals of earthquakes, this shaking level has a mean occurrence rate of 0.00211 yr−1 and a mean recurrence time of 475 years. Because this PML is the 90th percentile loss given this level of shaking, the PML-level loss can have a much longer mean recurrence time.
Commercial lenders often use PML to help decide whether to underwrite a mortgage. It is common, for example, for a commercial lender to refuse to underwrite a mortgage if the PML exceeds 20% to 30% of the replacement cost of the building, unless the buyer purchases earthquake insurance, a costly requirement that often causes the investor to decide against bidding. Once the PML hurdle is passed, the bidder usually proceeds to ignore seismic risk, for at least the following:
1. Irrelevant planning period. Investors plan on the order of 5 years, making loss corresponding to shaking intensity with a 500-year recurrence time largely irrelevant, too rare even for consideration in a sensitivity study.
2. Incompatibility with financial analysis. PML is a scenario value, not an ongoing cost that can be reflected in a cashflow analysis.
3. Custom. Investors are not required by custom or regulation to include seismic risk in the financial analysis.
Lacking any measure of economic risk beyond PML, the bidder has no basis for assessing how the seismic risk of a building should influence the purchase price or for judging whether seismic risk mitigation might be worth exploring. Faced with a high PML, the bidder might increase the discount rate used in the financial analysis to reduce the present value of the future net income stream, but no analysis aids the adjustment.
Another common term in earthquake loss estimation, namely expected annualized loss (EAL), measures the average yearly amount of loss when one accounts for the frequency and severity of various levels of loss. For comparison purposes, the current method to calculate EAL is discussed below as Method 1. If a user knows the EAL for a given property, they could include it as an operating expense in the financial analysis. However, current methods available to calculate EAL are time-consuming and cost prohibitive. Thus, a need exists for an accurate, effective, and affordable method to calculate EAL.